Question

Assume that an annual dividend of $2.00 per share was paid yesterday on Alpha Corp. common stock. Your client is considering investing in this stock, but she needs at least a 15% return to induce her to take on the riskiness of Alpha stock. If the dividend growth rate was expected to be 7% per year for the next five years, followed by 3% per year thereafter, what would be the maximum price you should tell your client to pay?

a $11.99
b $12.12
c $20.09
d $24.12

Answer 1

To calculate the maximum price your client should pay for Alpha Corp. common stock, you can use the Gordon Growth Model. The maximum price is $24.12.

Step-by-step explanation:

To calculate the maximum price your client should pay for Alpha Corp. common stock, we can use the Gordon Growth Model. The model is based on the formula: P0 = D1 / (r - g), where P0 is the price, D1 is the expected dividend in the next year, r is the required rate of return, and g is the dividend growth rate.

In this case, the expected dividend in the next year is $2.00 * (1 + 0.07) = $2.14, the required rate of return is 15%, and the dividend growth rate is 7% for the next five years and then 3% thereafter.

Using the formula, we can calculate: P0 = 2.14 / (0.15 - 0.07) = $24.12.

Therefore, the maximum price you should tell your client to pay for Alpha Corp. common stock is $24.12 (option d).